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Chapter 7

International Factor Movements

Prepared by Iordanis Petsas

To Accompany

International Economics: Theory and Policy, Sixth Edition

by Paul R. Krugman and Maurice Obstfeld

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Chapter Organization

Introduction
International Labor Mobility
International Borrowing and Lending
Direct Foreign Investment and Multinational Firms
Summary
Appendix: More on Intertemporal Trade

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Introduction

Movement of goods and services is one form of international integration.
Another form of integration is international movements of factors of production (factor movements).
Factor movements include:

Labor migration
Transfer of capital via international borrowing and lending
International linkages involved in the formation of multinational corporations

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International Labor Mobility

A One-Good Model Without Factor Mobility

Assumptions of the model:

There are two countries (Home and Foreign).
There are two factors of production: Land (T) and Labor (L).
Both countries produce only one good (refer to it as “output”).
Both countries have the same technology but different overall land-labor ratios.
Home is the labor-abundant country and Foreign is the land-abundant country.
Perfect competition prevails in all markets.

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International Labor Mobility

Labor, L

Output, Q

Q(T, L)

Figure 7-1: An Economy’s Production Function

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Rents

Wages

Real

wage

MPL

Labor, L

Marginal Product of labor, MPL

International Labor Mobility

Figure 7-2: The Marginal Product of Labor

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International Labor Movement

Suppose that workers are able to move between the two countries.

Home workers would like to move to Foreign until the marginal product of labor is the same in the two countries.

This movement will reduce the Home labor force and thus raise the real wage in Home.
This movement will increase the Foreign labor force and reduce the real wage in Foreign.

International Labor Mobility

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L²

International Labor Mobility

Figure 7-3: Causes and Effects of International Labor Mobility

MPL

MPL^*

Home

employment

Foreign

employment

O^*

L¹

Migration of labor

from Home to Foreign

Total world labor force

Marginal product

of labor

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The redistribution of the world’s labor force:

Leads to a convergence of real wage rates
Increases the world’s output as a whole
Leaves some groups worse off

Extending the Analysis

Modifying the model by adding some complications:

Suppose the countries produce two goods, one labor- intensive and one land-intensive.

Trade offers an alternative to factor mobility: Home can export labor and import land by exporting the labor-intensive good and importing the land-intensive good.

International Labor Mobility

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International movements of capital

Refer to borrowing and lending between countries

Example: A U.S. bank lends to a Mexican firm.

Can be interpreted as intertemporal trade

Refers to trade of goods today for goods in the future

International Borrowing and Lending

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Intertemporal Production Possibilities and Trade

Imagine an economy that consumes only one good and will exist for only two periods, which we will call present and future.
Intertemporal production possibility frontier

It represents a trade-off between present and future production of the consumption good.
Its shape will differ among countries:

Some countries will be biased toward present output.
Some countries will be biased toward future output.

International Borrowing and Lending

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Figure 7-4: The Intertemporal Production Possibility Frontier

Present

consumption

Future

consumption

International Borrowing and Lending

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The Real Interest Rate

How does a country trade over time?

A country can trade over time by borrowing or lending.
When a country borrows, it gets the right to purchase some quantity of consumption at present in return for repayment of some larger quantity in the future.

The quantity of repayment in future will be (1 + r) times the quantity borrowed in present, where r is the real interest rate on borrowing.
The relative price of future consumption is 1/(1 + r).

International Borrowing and Lending

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Intertemporal Comparative Advantage

Assume that Home’s intertemporal production possibilities are biased toward present production.

A country that has a comparative advantage in future production of consumption goods is one that in the absence of international borrowing and lending would have a low relative price of future consumption (i.e., high real interest rate).

High interest rate corresponds to a high return on investment.

International Borrowing and Lending

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Direct Foreign Investment �and Multinational Firms

Direct foreign investment

Refers to international capital flows in which a firm in one country creates or expands a subsidiary in another
Involves not only a transfer of resources but also the acquisition of control

The subsidiary does not simply have a financial obligation to the parent company; it is part of the same organizational structure.

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Direct Foreign Investment �and Multinational Firms

Multinational firms

A vehicle for international borrowing and lending
They provide financing to their foreign subsidiaries

Why is direct foreign investment rather than some other way of transferring funds chosen?

To allow the formation of multinational organization (extension of control)

Why do firms seek to extend control?

The answer is summarized under the theory of multinational enterprise.

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Direct Foreign Investment�and Multinational Firms

The Theory of Multinational Enterprise

Two elements explain the existence of a multinational:

Location motive

A good is produced in two (or more) different countries rather than one because of:

Resources
Transport costs
Barriers of trade

Internalization motive

A good is produced in different locations by the same firm rather than by separate firms because it is more profitable to carry transactions on technology and management.

Technology transfer
Vertical integration

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Direct Foreign Investment�and Multinational Firms

Multinational Firms in Practice

Multinational firms play an important part in world trade and investment.

Example: Half of U.S. imports can be regarded as transactions between branches of multinational firms, and 24% of U.S. assets abroad consist of the value of foreign subsidiaries of U.S. firms.

Multinational firms may be either domestic or foreign-owned.

Foreign-owned multinational firms play an important role in most economies, especially in the United States.

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Direct Foreign Investment �and Multinational Firms

Table 7-1: France, United Kingdom, and United States: Shares of Foreign-Owned Firms in Manufacturing Sales, Value Added, and Employment, 1985 and 1990 (percentages)

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Direct Foreign Investment �and Multinational Firms

Figure 7-5: Foreign Direct Investment in the United States

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Summary

International factor movements can sometimes substitute for trade.
International borrowing and lending can be viewed as a kind of international trade of present consumption for future consumption rather than trade of one good for another.
Multinational firms primarily exist as ways of extending control over activities taking place in two or more different countries.

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Summary

Two elements explain the existence of a multinational:

A location motive.
An internalization motive.

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Appendix: �More on Intertemporal Trade

Present

consumption

Future

consumption

Q_P

Q_F

Intertemporal

production

possibility

frontier

Isovalue lines with slope – (1 + r)

Investment

Figure 7A-1: Determining Home’s Intertemporal Production Pattern

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Appendix: �More on Intertemporal Trade

Q_P

Q_F

Indifference curves

Exports

Intertemporal budget constraint,

D_P + D_F/(1 + r) = Q_P +Q_F/(1 + r)

Imports

Present

consumption

Future

consumption

Figure 7A-2: Determining Home’s Intertemporal Consumption Pattern

D_P

D_F

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Appendix: �More on Intertemporal Trade

D^*_P

D^*_F

Imports

Q^*

Q^*_P

Q^*_F

Intertemporal budget constraint,

D^*_P + D^*_F/(1 + r) = Q^*_P +Q^*_F/(1 + r)

Exports

Present

consumption

Future

consumption

D^*

Figure 7A-3: Determining Foreign’s Intertemporal Production and Consumption Patterns

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Appendix: �More on Intertemporal Trade

(Q_P– D_P) = (D^*_P– Q^*_P)

(Q^*_F– D^*_F) =

(D_F– Q_F)

Figure 7A-4: International Intertemporal Equilibrium in Terms of Offer Curves

Home exports of present consumption

(Q_P– D_P) and Foreign imports of future consumption (D^*_P– Q^*_P)

Foreign exports of future

consumption (Q^*_F– D^*_F) and Home

imports of future consumption (D_F– Q_F)

slope = (1 + r¹)